Equity and Debt

First some revision

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 Debt /Equity
Can the Value of the company be affected by changing
the proportions of debt and equity used to finance the
company?
i.e. if debt is 7% and equity 12% then
1. 30%Debt and 70% equity
Wacc = .3 x 7 + .7 x 12 =
2.1 + 8.4 = 10.5
Will
2. 50% debt and 50% equity
Wacc = .5 x 7 + .5 x 12 =
3.5 + 6 = 9.5
or

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 Debt /Equity
Or Will the increased risk cause the required
rate of return on equity to rise such that
there is no advantage?

.5 x 7 + .5 x 14 =
3.5 + 7 = 10.5

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 Debt /Equity
Argument continued until Modigliani and
Miller on assumption of perfect markets,
with the arbitrage proof, proved that a
company cannot add value by doing
something, borrow money, that a
shareholder could do for themselves.
Value only comes from what is produced,
not how it is financed

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 Debt /Equity
But reintroduce some imperfections,
bankruptcy costs, financial distress and so
on but mainly
Tax
Assuming taxable income and therefore a
tax shield then -

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 Debt /Equity
CoA CoB
EBIT 805 805
Int 105 ___
EBT 700 805
Tax @ 40% 280 322
420 483

Capital Equity 3,500 5,000

Debt 1,500 @ 7% -
ROE = 420/3,500 = 12% 483/5,000 = 9.7%
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 Debt /Equity
What if interest taken after tax?
EBIT 805
Tax @ 40% 322
EBI 483
Int 105
Net 378
378/3,500 = 10.8%
12 10.8 = 1.2%
And 105 x .4 = 42 and 42/3,500 = 1.2%
So extra 1.2% a gift from the government
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 Debt /Equity
Increase debt to 50% stil at 7%
EBIT 805
Int 175
EBT 630
Tax 252
Net 378
378/2,500 = 15.12%
But if required return = 14% then
378/.14 = 2,700

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 Debt /Equity
So a decision to be made
How much debt and how much equity?
- Industry norms
- Coverage ratios
- Asset types
- Non debt tax shields
- Size
- Earnings volatility
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 Equity
Sources of equity
Angels, Venture capital, Institutional
Investors, Corporate investors
Focus on IPOs
Initial Public Offering or Flotation

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 Equity
Primary and Secondary Offerings
Primary Offering
New shares available in a public offering that raise
new capital

Secondary Offering
Shares sold by existing shareholders in an equity
offering

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 Equity
PREFERRED STOCK
DEFINITION
Capital stock which provides a specific dividend that is paid before any
dividends are paid to common stock holders, and which takes precedence
over common stock in the event of a liquidation. Like common stock,
preferred stocks represent partial ownership in a company, although
preferred stock shareholders do not enjoy any of the voting rights of
common stockholders. Also unlike common stock, a preferred stock pays a
fixed dividend that does not fluctuate, although the company does not have
to pay this dividend if it lacks the financial ability to do so. The main benefit
to owning preferred stock is that the investor has a greater claim on the
company's assets than common stockholders. Preferred shareholders
always receive their dividends first and, in the event the company goes
bankrupt, preferred shareholders are paid off before common stockholders.
In general, there are four different types of preferred stock:
cumulative preferred, non-cumulative, participating, and convertible. also
called preference shares.
This content can be found on the following page:
http://www.investorwords.com/3778/preferred_stock.html

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 Equity
Reasons for listing
Liquidity
Better access to capital

But
investors more widely dispersed so Agency issues.
The firm must satisfy all of the requirements of
public companies.
SEC filings, Sarbanes-Oxley, Stock Exchange
Listings etc.

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 Equity
Procedure similar in UK and USA
Appointment of lead manager/ underwriter
Lead manager will pull together a syndicate.
Multinational IPOs may have as many as three
syndicates to cover e.g. UK and Europe, USA
and Canada, Far East.
Legal advisors
Lead managers will market the IPO
Roadshows,
Lead manager will be involved in advising on
price.
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 Equity
Lead manager will be involved in advising on price.
Price arrived at by
1) NPV methodology or
2) Using comparables
A company that is planning an IPO appoints lead
managers to help it decide on an appropriate price at
which the shares should be issued. There are two ways
in which the price of an IPO can be determined: either
the company, with the help of its lead managers, fixes a
price or the price is arrived at through the process of
book building.

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 Equity
Process
During the fixed period of time for which the subscription
is open, the book runner collects bids from investors at
various prices, between the floor price and the cap price.
Bids can be revised by the bidder before the book
closes. The process aims at tapping both wholesale and
retail investors. The final issue price is not determined
until the end of the process when the book has closed.
After the close of the book building period, the book
runner evaluates the collected bids on the basis of
certain evaluation criteria and sets the final issue price.
If demand is high enough, the book can be
oversubscribed. In these case the greenshoe option is
triggered.
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 Equity
Methods of selling
- Best efforts basis
Underwriter does not guarantee that all the
stock will be sold.
May have an - All or None contract
- Firm commitment
Where the underwriter guarantees the sale of the
shares at the offer price and will purchase all of the
shares. If the price drops they are in trouble
- Bought deal
- Auction
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 Equity
In the business of initial public offering, the underwriting contract is the contract
between the underwriter and the issuer of the common stock. the following types of
underwriting contracts are most common.[1]
In the firm commitment contract the underwriter guarantees the same of the issued
stock at the agreed-upon price. For the issuer, it is the safest but the most expensive
type of the contracts, since the underwriter takes the risk of sale.[1]
In the best efforts contract the underwriter agrees to sell as many shares as
possible at the agreed-upon price. [1]
Under the all-or-none contract the underwriter agrees either to sell the entire
offering or to cancel the deal. [1]
Stand-by underwriting, also known as strict underwriting or old-fashioned
underwriting is a form of stock insurance: the issuer contracts the underwriter for the
latter to purchase the shares the issuer failed to sell under stockholders' subscription
and applications. [2]
[edit] References
^ a b c d "The Investment Banking Handbook" by J. Peter Williamson, 1988,
ISBN 0471815624 , ""Underwriting Contracts", p. 128
^ "The Law of Securities Regulation" by Thomas Lee Hazen, 1996, ISBN
0314085874, p. 405.
Retrieved from "http://en.wikipedia.org/wiki/Underwriting_contract"

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 Equity
A bought deal occurs when an underwriter, such as an investment bank or a
syndicate, purchases securities from an issuer before selling them to the public. The
investment bank (or underwriter) acts as principal rather than agent and thus actually
"goes long" in the security. The bank negotiates a price with the issuer (usually at a
discount to the current market price, if applicable).
The advantage of the bought deal from the issuer's perspective is that they do not
have to worry about financing risk (the risk that the financing can only be done at a
discount too steep to market price.) This is in contrast to a , where the underwriters
have to "market" the offering to prospective buyers, only after which the price is set.
The advantages of the bought deal from the underwriter's perspective include:
Bought deals are usually priced at a larger discount to market than fully marketed
deals, and thus may be easier to sell; and
The issuer/client may only be willing to do a deal if it is bought (as it eliminates
execution or market risk.)
The disadvantage of the bought deal from the underwriter's perspective is that if it
cannot sell the securities, it must hold them. This is usually the result of the market
price falling below the issue price, which means the underwriter loses money. The
underwriter also uses up its capital, which would probably otherwise be put to better
use (given sell-side investment banks are not usually in the business of buying new
issues of securities.)

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 Equity
Best-Efforts, Firm Commitment and
Auction IPOs
Auction IPO
A method of selling new issues directly to the
public
Rather than setting a price itself and then allocating
shares to buyers, the underwriter in an auction IPO takes
bids from investors and then sets the price that clears
the market.

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 Equity
Example 23.2

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 Equity
The Mechanics of an IPO
Underwriters and the Syndicate
Lead Underwriter
The primary investment banking firm responsible
for managing a security issuance

Syndicate
A group of underwriters who jointly underwrite and
distribute a security issuance

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 Equity
The Mechanics of an IPO (cont'd)
SEC Filings
Registration Statement
A legal document that provides financial and other
information about a company to investors prior to a
security issuance

Preliminary Prospectus (Red Herring)

Part of the registration statement prepared by a
company prior to an IPO that is circulated to
investors before the stock is offered

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 Equity
The Mechanics of an IPO (cont'd)
SEC Filings
Final Prospectus
Part of the final registration statement prepared by
a company prior to an IPO that contains all the
details of the offering, including the number of
shares offered and the offer price

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 Equity
The Mechanics of an IPO (cont'd)
Valuation
There are two ways to value a company.
Compute the present value of the estimated future
cash flows.
Estimate the value by examining comparables
(recent IPOs).

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 Equity
Example 23.3

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 Equity
Example 23.3 (cont'd)

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 Equity
Greenshoe Provision
Allows the underwriter to issue more shares up
to an agreed %
E.g. Issue 3,000,000 at 12.50
Greenshoe provision 15% or 450,000
Short sell full 3,450,000
If successful and price met then exercise
Greenshoe provision
If unsuccessful then can fulfil obligation by
purchasing in the market with the benefit that
this will provide some support for the price
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 Equity
IPO Puzzles
Underpricing
Generally, underwriters set the issue price so
that the average first-day return is positive.
As mentioned previously, research has found that
75% of first-day returns are positive.
The average first day return in the United States is
18.3%.

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 Equity
IPO Puzzles (cont'd)
Underpricing
The underwriters benefit from the
underpricing as it allows them to manage their
risk.
The pre-IPO shareholders bear the cost of
underpricing. In effect, these owners are
selling stock in their firm for less than they
could get in the aftermarket.

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Figure 23.3
International
Comparison
of First Day
IPO Returns

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 Equity
IPO Puzzles (cont'd)
Underpricing
Although IPO returns are attractive, all investors
cannot earn these returns.
When an IPO goes well, the demand for the stock
exceeds the supply. Thus the allocation of shares for
each investor
is rationed.
When an IPO does not go well, demand at the issue
price is weak, so all initial orders are filled completely.
Thus, the typical investor will have their investment in good
IPOs rationed while fully investing in bad IPOs.

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 Equity
Cyclicality of IPOs
The number of issues is highly cyclical.
When times are good, the market is flooded
with new issues; when times are bad, the
number of issues
dries up.

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 Figure 23.4 Cyclicality
of Initial Public Offerings

in the United States,

(19752004)
 Equity
Costs of Issuing an IPO
A typical spread is 7% of the issue price.
By most standards this fee is large, especially
considering the additional cost to the firm
associated with underpricing.
It is puzzling that there seems to be a lack of
sensitivity of fees to issue size.
One possible explanation is that by charging lower
fees, an underwriter may risk signaling that it is not
the same quality as its higher-priced competitors.
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 Figure 23.5
Relative Costs of Issuing Securities

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 Equity
Long-Run Underperformance
Although shares of IPOs generally perform

very well immediately following the public

offering, it has been shown that newly
listed
firms subsequently appear to perform
relatively poorly over the following three to
five years after their IPOs.

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 Equity
The Seasoned Equity Offering
Seasoned Equity Offering (SEO)
When a public company offers new shares for
sale
Public firms use SEOs to raise additional equity.
When a firm issues stock using an SEO, it follows
many of the same steps as for an IPO.
The main difference is that a market price for the stock
already exists, so the price-setting process is not
necessary.

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 Equity
The Mechanics of an SEO
Primary Shares
New shares issued by a company in an equity
offering

Secondary Shares
Shares sold by existing shareholders in an
equity offering

Tombstones
A newspaper advertisement in which an
underwriter advertises a security issuance
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 Equity
The Mechanics of an SEO (cont'd)
There are two types of seasoned equity
offerings.
Cash Offer
A type of SEO in which a firm offers the new shares to
investors at large

Rights Offer
A type of SEO in which a firm offers the new shares
only to existing shareholders
Rights offers protect existing shareholders from underpricing.

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 Equity
Price Reaction
Researchers have found that, on average,

the market greets the news of an SEO

with a
price decline.
This is consistent with the adverse selection
discussed in Chapter 16.

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Figure 23.7 Post-SEO
Performance

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 Equity
Costs
Although not as costly as IPOs, seasoned
offerings are still expensive.
Underwriting fees amount to 5% of the
proceeds of
the issue.
Rights offers have lower costs than cash offers.

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 Equity

Any Questions?

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